Bond Traders Shunning Freddie Costs Taxpayers: Mortgages

Freddie Mac still competes with Fannie Mae even now that they’re both 80 percent owned by the government after their 2008 bailouts. Photographer: Andrew Harrer/Bloomberg

June 26 (Bloomberg) -- The bond market is telling Freddie
Mac it’s not wanted even as taxpayers support two similar
mortgage-finance companies.

Home-loan securities it guarantees are hovering near record
low prices relative to the debt of its larger rival Fannie Mae.
That’s forcing Freddie Mac to rebate lenders that package
mortgages into its bonds to compensate them for investors paying
less for the debt, according to its disclosures and people
familiar with its Market-Adjusted Pricing program. Banks slice
off part of homeowner payments to buy its insurance.

Freddie Mac still competes with Fannie Mae even now that
they’re both 80 percent owned by the government after their 2008
bailouts. Expenses from the program may reach about $750 million
annually, according to JPMorgan Chase & Co. analysts. The costs
and the McLean, Virginia-based company’s dwindling share of the
$4 trillion market are adding fuel to discussions about
introducing interchangeable Fannie Mae and Freddie Mac
securities, a potential step toward reforming the $10 trillion
U.S. housing-finance system as lawmakers ponder its future.

It’s “amazing” that Freddie Mac is disrupting the way
markets normally work, said Scott Simon, who helps run the
world’s largest bond fund at Pacific Investment Management Co.

‘Artificial Supply’

“The market is essentially saying they don’t want them,”
said Simon, the mortgage-securities head at Newport Beach,
California-based Pimco. “There’s no demand and artificial
supply because Freddie is paying originators to make them.”

Prices between the two companies’ bonds differ in part
because Freddie Mac securities are more difficult to buy and
sell in bulk, according to investors such as Simon, Columbia
Management Investment Advisers LLC’s Jason Callan and BlackRock
Inc.’s Akiva Dickstein. There’s also the perception that Freddie
Mac loans are more prone to refinancing, which can damage
holders, they said.

Brad German, a spokesman for Freddie Mac, declined to
comment. The Federal Housing Finance Agency, the overseer of the
company and Washington-based Fannie Mae, declined to comment on
the bond prices and payments.

Fannie Mae and Freddie Mac help fund loans to purchase or
refinance homes and apartment buildings mainly by guaranteeing
mortgage-backed securities. The two firms and other government-backed organizations such as the Federal Housing Administration
have been involved in more than 90 percent of residential
lending over the past four years as housing slumped.

Home prices fell in April at the slowest pace in more than
a year, data released today showed, adding to signs the market
is firming. The S&P/Case-Shiller index of property values in 20
cities dropped 1.9 percent from the same month in 2011, the
smallest decline since November 2010.

Freddie Founding

Freddie Mac was created as a private company in 1970 to
provide competition for Fannie Mae, which was formed in 1938 as
part of President Franklin D. Roosevelt’s New Deal and then
split off from the government in 1968 while retaining certain
perks and the aura of taxpayer backing. Freddie Mac issued its
first home-loan securities in 1971, one year after the separate
U.S.-owned Ginnie Mae and a decade before Fannie Mae, which
surpassed its rival in the mortgage-bond market in the 1980s.

Fannie Mae and Freddie Mac were seized by the U.S. as the
companies’ losses from the housing slump they helped fuel
threatened to deepen the crash. They’ve since been run under
conservatorships overseen by the FHFA, with the Securities
Industry and Financial Markets Association describing the
process as often creating “separate operational silos.”

Reducing that duplication “is necessary and appropriate to
serve the interests of the taxpayers who own the majority of
each,” Sifma, Wall Street’s largest lobbying group, said in a
comment letter to the regulator this month.

TBA Contracts

The group is charged with setting the rules for so-called
To Be Announced, or TBA, trading of government-backed mortgage
securities, the backbone of U.S. lending that’s responsible for
most of the volume. TBA contracts allow orders to buy bonds to
be filled by any debt matching a range of characteristics,
allowing originators to hedge their pipelines of pending loans.

In theory, Freddie Mac’s securities, known as Gold
participation certificates, or PCs, should trade at premiums in
that market because they pay investors on the 15th of every
month, rather than the 25th as Fannie Mae’s do, an advantage
worth about 4/32 of a cent on the dollar. Instead, they
traditionally lag behind, with the gap ballooning last year.

Freddie Mac’s 4.5 percent 30-year securities were trading
at the end of last week at about 15/32 of a cent less than
similar Fannie Mae debt, according to data compiled by
Bloomberg. That’s more than four times the average since the
notes began trading in 2003, and an amount that JPMorgan’s top-ranked mortgage-bond analysts referred to as “distressed
levels” earlier this year.

Lender Refunds

For their 3.5 percent bonds, into which most new loans are
now getting packaged, the gap is about 7/32 of a cent.

While that’s a fraction of the debt’s prices of almost 105
cents, based on its about $300 billion a year in issuance,
Freddie Mac may spend about $750 million in refunds to lenders
as result of such a gap, JPMorgan analysts led by Matt Jozoff
estimated in a March report. Last year, when offering an $875
million figure for 2010, the analysts said their methodology
produces an “overestimate, however, because Freddie can use
other means to entice originators.”

The details of the payments are kept secret. Formulas
determining the amount of compensation can vary between
different lenders, and are usually set out as part of agreements
Freddie Mac and Fannie Mae strike with mortgage originators to
gather more of their business, said one of the people familiar
with the matter, who didn’t want to be identified discussing
confidential contracts or a business partner. Smaller lenders,
which typically pay more for their bond insurance as a result of
the market-share deals, may not get any refunds, they said.

‘More Equal’

“We’re trying to get prices that the companies charge
different-sized lenders to be more equal,” FHFA Chief Economist
Patrick Lawler said in a telephone interview. “There have been
improvements in that area, and we expect more.”

Spokespeople for Wells Fargo & Co., JPMorgan and Citigroup
Inc., the three largest U.S. mortgage lenders, declined to
comment, as did those for Bank of America Corp. and US Bancorp.,
Freddie Mac’s second-largest customer.

Freddie Mac said in its annual report that “in certain
cases, we compensate customers for the differences between our
PCs and comparable Fannie Mae securities.”

Lenders typically aren’t paid the entire difference between
Freddie Mac bond prices and those on Fannie Mae securities, four
executives said. That means they must settle for lower profits
when doing a loan with Freddie Mac that Fannie Mae would accept,
or offer higher rates to consumers.

Profit Margins

Profit margins are now so wide because of reduced capacity
across the industry that the gap after the refunds is
inconsequential, two executives said. Still, some lenders see no
reason to deal with Freddie Mac other than with the federal Home
Affordable Refinance Program, under which debt stays with its
original guarantor, and niche products with easier terms, two
others said.

Originators may also continue to send loans to Freddie Mac
for reasons without up-front benefits, such as a less aggressive
use of rights to force buy backs due to faulty underwriting.
Bank of America and Fannie Mae stopped doing new business this
year as a result of a battle over bad loans.

Freddie Mac mortgage bond issuance is still dwindling. It
totaled 50.7 percent of Fannie Mae sales in the first five
months of this year, down from an average of 60 percent from
2008 through 2010, Bloomberg data show.

‘Difficult, Expensive’

Freddie Mac warned in its annual report that a decline in
its market share could cost it revenue and be “difficult or
expensive to reverse.” Lessened issuance can feed upon itself
by reducing liquidity, which is important to bondholders.

An investor can easily trade “a couple of hundred
million” of dollars of Fannie Mae 15-year debt at the market
prices quoted by dealers, said Callan, head of structured
products at Minneapolis-based Columbia Management, which manages
about $165 billion in fixed-income assets.

It would be “very challenging” with similar Freddie Mac
bonds, he said. “The guy’s going to bid you back from what you
see on the screens.” Pimco’s Simon agreed, saying he could sell
$500 million of Fannie Mae securities and “only slightly
cheapen” prices and that’s not the case for Freddie Mac debt.

Trading data that the Financial Industry Regulatory
Authority began disclosing last year shows the greater liquidity
of Fannie Mae’s notes relative to Freddie Mac’s. The information
itself “has reinforced awareness” of the difference, Deutsche
Bank AG analyst Steve Abrahams said in a report this month.

Trading Volumes

Trading of Fannie Mae’s 30-year securities in the TBA
market has recently averaged 10 times the volume of similar
Freddie Mac debt, according to the report. In contrast, Fannie
Mae’s $1.41 trillion of bonds outstanding and not repackaged
into so-called collateralized mortgage obligations are only 2.05
times greater than Freddie Mac’s.

Deutsche Bank says the perception that Freddie Mac loans
are more prone to refinancing has become “incorrect,” and
Credit Suisse Group AG and JPMorgan analysts agree prepayment
speeds on the securities aren’t consistently higher. Refinancing
damages investors that paid more than face value for bonds by
returning their principal faster at par and curbing interest
payments.

The default-risk of Freddie Mac debt is lower based on the
way their Treasury Department backstops work, according to Jim
Vogel, a debt analyst at FTN Financial. The company has tapped
taxpayers for less, partly as a result of its reliance on better
quality borrowers and lenders that refinance more, leaving it
with more aid available after this year when their bailouts are
scheduled to become no longer unlimited.

Turned Profitable

Fannie Mae has drawn $115 billion in capital from the
Treasury, while Freddie Mac has taken $72 billion, leaving
Fannie Mae with about $125 billion and Freddie Mac with about
$150 billion. While both have turned profitable this year, the
companies must pay 10 percent dividends on the amounts drawn.

Freddie Mac’s securities may also be suffering as the two
firms are forced under their bailout agreements to shrink the
portfolios of bonds and loans they hold on their balance sheets.

The FHFA this year directed Freddie Mac to stop engaging in
transactions “primarily” intended to support the prices of its
securities, its annual report shows. The disclosure followed an
article by ProPublica and National Public Radio critical of its
retention of so-called inverse floaters, which they described as
the company betting against homeowner refinancing.

Freddie Mac’s portfolio shrank last month by about $9.5
billion to $591.9 billion, with holdings of its own securities
falling to $189.8 billion, down from $260.7 billion a year
earlier, according to data released today.

Strategic Plan

Freddie Mac’s bond weakness adds incentive to create a
market in which securities guaranteed by either or both could be
delivered to investors placing orders, according to Morgan
Stanley, JPMorgan and Bank of America analysts. That would give
the firm access to the liquidity of the Fannie Mae market.

The FHFA, in a strategic plan for the two companies’
conservatorships released in February, said it wants to create a
single “platform” for issuing mortgage bonds that could be
used by any future versions of the firms or new rivals.

That could involve eliminating differences in technology
and items such as the debt’s payment dates and disclosures,
without creating interchangeable bonds. Lawler, the FHFA
economist, said the first idea is a near-term focus, though “a
single platform may involve a single security for Fannie Mae and
Freddie Mac.”

“We’re at the early stages, and we’re not yet in a
position to come out to the market saying here’s what we’re
proposing,” he said.

Interchangeable Debt

The Mortgage Bankers Association has called for
interchangeable debt. Sifma wants to explore potential
“solutions” to liquidity issues, said Richard A. Dorfman, head
of its securitization group.

Potential approaches may depend on the FHFA’s ability and
willingness to eliminate “inconsistencies” between the two
companies, which would be good for everyone from taxpayers,
homebuyers and builders to bond investors and dealers, he said.

Credit Suisse and Morgan Stanley say there are risks that a
change handled incorrectly could make it harder for investors to
buy and sell the debt. Reworking the market faces also faces
challenges including the firms’ separate U.S. backing and
perceived prepayment differences.

Pimco’s Simon said their regulator should erase refinancing
differences by aligning their underwriting to create a joint
market.

Housing Transition

“Given they’re both government-controlled and responsible
to the same taxpayers” it “strikes me as odd” that the FHFA
may not be able to do this because they are being run
separately, he said. “They need to make Golds not trade like
they’re diseased. You cannot move to single delivery contract as
long as Golds trade terribly and they prepay differently,”
Simon said, referring to the Freddie Mac securities.

Andrew Davidson, head of consulting and analytics firm
Andrew Davidson & Co., says the firms’ must be kept separate at
least until U.S. housing finance transitions to a new model “in
case something goes wrong at one of them” that would jeopardize
the financial system.

Moving to interchangeable securities is easier said than
done because it may require policy makers to take steps that
will affect the ultimate future of the companies, which they
have been reluctant to tackle, FTN’s Vogel said.

‘Pandora’s Boxes’

“It opens a series of tiny Pandora’s boxes that they don’t
want to start opening,” he said.

While it may be possible for the FHFA, dealers and investors
to change the market before the government’s future role in
housing gets decided, the lack of clarity could hinder decision-making, said Dickstein, a managing director at New York-based
BlackRock, the world’s largest asset manager.

“The question becomes, do you want to do all that if you
don’t know what the final product is going to be?” said
Dickstein, whose firm joins Pimco in saying the market will need
some version of government-backed bonds. “On the other hand, it
could improve liquidity and reduce taxpayer costs.”